I think Ryan explains it well enough even though I haven't run into the problem myself. At T-39 it seems that Windows Setup goes through all the CAT files and integrates them with some master file among other things, but I'm not really certain.
I believe it depends on the update. I've been looking into this myself by trying to figure out how Ryan does his thing in his currently available packs and through other sources like Gnome's WMP10 Slipstreaming thread on MSFN.
Some do seem to only require updated pre-existing files in I386 and their CATs. Not all
of the files, but the one(s) in the UPDATE directory created after extracting the hotfix. This will
work fine. But Windows Update will not see these updates as installed without their corresponding registry entries. The full reg entries can be found in the update.inf file within each hotfix package with a bit of work and some understanding of how INF files are structured. I like the elegance of Ryan's method of selectively adding the entries so that they don't show in Add/Remove Programs.
Some other hotfixes add extra files to I386 that need to be listed in txtsetup.sif and dosnet.inf (and perhaps others I'm not aware of) in addition of the CATs and reg entries to function and be detected properly.
Still others consist of only registry entries.
I'm still trying to work out all the nuances myself.